Fed on track to keep target rate at 5.25% for the rest of 2007 and probably well into 2008

[Gentle reminder: I may suspend this weekly post in the near future, but I haven't decided for sure yet.]

The market continues to flip-flop over whether the Fed will or won't cut rates in 2008, this past week flopping back to expecting a cut in Q1 of 2008. There will probably be enough ambiguity and disagreement over the economic outlook for the next several quarters to keep the market completely on edge and wildly flipping and flopping when looking out six months to a year. The good news is that there is a reasonably strong consensus that the economy will hang in there reasonably well for at least the Q3 and Q4, but until we get a firm reading on Q2 and even Q3, it will be difficult to convince some people that the economy is actually beginning to pick up again. It is unfortunate, but a lot of people seem to be assuming that the economy will weaken towards the end of the year into 2008, even though the Fed is forecasting that the economy will in fact strengthen into 2008.

My overall assessment of Fed monetary policy remains:

The Fed will keep the target rate at 5.25% for the rest of 2007, and probably well into 2008.

There will not be a recession this year or next, nor even enough of a growth slump to trigger a Fed rate cut.

The Fed will not cut rates in response to the concern about subprime mortgages.

The Fed will not worry about the health of the economy since it is MUCH healthier than the 0.7% Q1 "real" GDP growth rate "estimate" suggests.

I would suggest that there is a 1 in 3 chance that the Fed will hike rates by a quarter-point before the end of the year.

My current feeling is that the 0.7% Q1 GDP number has frightened so many people (and emboldened so many bears and cynics) that the Fed will likely simply wait until the Q2 and Q3 GDP numbers "print" before seriously considering a rate hike to make sure that the strength we were seeing in Q2 is really sustainable.

Please note that current Fed policy at 5.25%, or even a hike to 5.50%, is not restrictive, but within the neutral range which is neither accommodative nor restrictive (approximately 4.25% to 5.75%.) All "normal" economic activities can be easily financed with Fed policy at this level. This does eliminate a lot of excessive speculative behavior, but won't crimp the average business or consumer. The odds of such a hike causing a recession are negligible.

As of Friday, Fed funds futures contracts indicate the following probabilities for changes in the Fed funds target rate at upcoming FOMC meetings:

• August 7, 2007: 4% chance of a cut -- slam dunk for no change
• September 18, 2007: 10% chance of a cut
• October 30/31, 2007: 16% chance of a cut
• December 11, 2007: 36% chance of a cut
• January 2008: 52% chance of a cut -- flip a coin, but leaning towards a cut
• March 2008: 70% chance of a cut -- cut is likely
• May 2008: 88% chance of a cut
• June 2008: 100% chance of a cut

The August FOMC meeting is well within the 45-day window of reliability for fed funds futures to predict Fed action, so it is a virtual certainty that the Fed will not change the fed funds target rate at the August FOMC meeting. It is too soon for fed funds futures to reliably predict rates for the September or October FOMC meetings.

The futures market is forecasting a cut in Q1, but even January is too far in the future for futures to be a dependable indicator. Also, sometimes the last cut (or hike) forecast by futures is frequently an insurance hedge by vestors rather than an outright bet on the actual outcome.

-- Jack Krupansky